CONFIDENTIAL

FCF and Economic Profit

Valuation
Greg Collett
greg.collett@credit-suisse.com
+44 207 88 33 643

David Holland
david.a.holland@credit-suisse.com
+44 207 88 33 645
 CONFIDENTIAL

What Is Free Cash Flow?

Free cash flow is the cash flow available to all providers of Capital.
It is the after-tax operating profit (NOPAT) of the firm less any new investment in
operating assets. This measure does not consider historic investments.

FCF calculation:

Income Balance
Statement Sheet T -1

Balance
Sheet T

NOPAT ∆ Invested Capital FCF

FCF = NOPAT – Change in Invested Capital

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 CONFIDENTIAL

Calculation of NOPAT, ∆ Invested Capital and FCF

This simple example illustrates how the components of free cash flow are calculated.

Income Statement Balance Sheet

Dec-07 Dec-08 Dec-07 Dec-08
Revenue 100 90 Current Assets 20 24
- Cost of Goods Sold 40 37 Accounts Receivable 15 17
= Gross Profit 60 53 Inventory 5 7
Other Current Assets 0 0
- Operating Expenses 50 45
= Operating Profit 10 8 - Current Liabilities 14 12
Accounts Payable 12 11
- Cash Tax @ 30% 3 2.4 Tax 2 1
Other Current Liabilities 0 0
= NOPAT 7 5.6
- Change in Invested Capital -4 = Working Capital 6 12

= FCF 11 + Fixed Assets 32 30

Invested Capital 38 42

Change in Invested Capital -4

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 CONFIDENTIAL

What Is Economic Profit?

Traditional accounting measures such as net income ignore the opportunity cost of
capital tied up to generate earnings. Economic Profit is a measure of the residual or
economic value generated on the Invested Capital.

Economic Profit calculation:

Income Balance
Statement Sheet

Invested Capital

Cost of Capital

NOPAT Capital Charge EP

EP = NOPAT – Capital Charge or EP = (ROIC – DR) x Invested Capital

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 CONFIDENTIAL

Calculation of NOPAT and Invested Capital

This simple example illustrates how the components of Economic Profit are calculated.

Income Statement Balance Sheet

Dec-07 Dec-08 Dec-07 Dec-08
Revenue 100 90 Current Assets 20 24
- Cost of Goods Sold 40 37 Accounts Receivable 15 17
= Gross Profit 60 53 Inventory 5 7
Other Current Assets 0 0
- Operating Expenses 50 45
= Operating Profit 10 8 - Current Liabilities 14 12
Accounts Payable 12 11
- Cash Tax @ 30% 3 2.4 Tax 2 1
Other Current Liabilities 0 0
= NOPAT 7 5.6
= Working Capital 6 12

+ Fixed Assets 32 30
Invested Capital 38 42

Capital Charge @ 10% 4.2

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 CONFIDENTIAL

Calculation of Economic Profit

The Economic Profit is calculated according to both methods in this example.

Income Statement Balance Sheet
Dec-07 Dec-08 Dec-07 Dec-08
Revenue 100 90 Current Assets 20 24
- Cost of Goods Sold 40 37 Accounts Receivable 15 17
= Gross Profit 60 53 Inventory 5 7
Other Current Assets 0 0
- Operating Expenses 50 45
= Operating Profit 10 8 - Current Liabilities 14 12
Accounts Payable 12 11
- Cash Tax @ 30% 3 2.4 Tax 2 1
Other Current Liabilities 0 0
= NOPAT 7 5.6
- Capital Charge @ 10% 4.2 = Working Capital 6 12

= EP (method 1) 2.8 + Fixed Assets 32 30

Invested Capital 38 42

ROIC (NOPAT/Inv Cap) 16.7% Capital Charge @ 10% 4.2

- WACC 10%
Spread 6.7%
x Invested Capital 42
= EP (method 2) 2.8

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 CONFIDENTIAL

Calculating the Value of a Firm

Economic a Profit indicates whether firm is creating economic value or destroying it. The
value of a firm is related to the present value of its future EP and FCF streams.

EP Valuation: FCF Valuation:

Income Balance Income Balance
Statement Sheet Statement Sheet T -1

Balance
Sheet T

Invested Capital

Cost of Capital

NOPAT Capital Charge EP NOPAT ∆ Invested Capital FCF

Corporate Invested Present Value of Corporate Present Value of Future FCF

Value Capital Future EP Streams Value Streams

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 CONFIDENTIAL

Calculating the Terminal Value of a Firm

Also called perpetual, continuing or residual value, the terminal value is an estimate of
the firm’s value after its explicit forecast period is complete and typically makes up 75%
or more of the corporate value.

Corporate Value of Forecast Value of Terminal

Value Period Period

Free Cash Flow Terminal Period Valuation

∞
N = Forecast horizon
FCFi
Value = ∑ i = calculation year
i =1 (1 + DR )i
⎛ g ⎞
⎟(1 + g ) for i > N
i−N
FCFi = NOPATi − g × InvestedCapital i −1 = NOPATN +1 ⎜1 −
⎝ ROIC ⎠

∞
N
FCFi
Value = ∑ FCFi + ∑ (1 + DR ) i
i =1 i = N +1
Assumes zero FCF growth or fade in ROIC

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 CONFIDENTIAL

FCF Terminal Period Valuation

Simple analytical solutions can be derived for the valuation of the terminal period if
growth and returns are assumed to be constant.

(1) Zero Growth (2) Constant Growth

FCFi = NOPATN +1 for i > N ⎛ g ⎞

N ∞
NOPAT N +1 ⎜ 1 − ⎟ (1 + g )i − N −1

Value = ∑ FCFi + ∑ ⎝ ROIC ⎠

(1 + DR )i
∞
N
NOPATN +1
Value = ∑ FCFi + ∑ (1 + DR ) i
i =1 i = N +1

i =1 i = N +1

⎛ g ⎞
NOPAT ⎜ 1 − ⎟
N
NOPATN +1 N N +1
⎝ ROIC ⎠
Value = ∑ FCFi + Value = ∑ FCFi +
DR(1 + DR ) (DR − g )(1 + DR )N
N
i =1 i =1

Trick: use perpetuity model Trick: use Gordon growth model

Assumes all future growth is cost of Assumes no fade in ROIC or g after

capital. forecast.

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 CONFIDENTIAL

Tips & Tricks for FCF Valuation (1)

New investments made in the terminal period have a return of ROICI. Investments made
during the explicit period maintain their last explicit return ad infinitum.
Growth in this case refers to the growth in NOPAT during the terminal period.

What if returns in the explicit and terminal period are different?

⎛ g ⎞
NOPATN +1 ⎜⎜1 − ⎟⎟
⎝ ROIC I
N
Value = ∑ FCFi + ⎠
i =1 (DR − g )(1 + DR )N

Growth in this equation refers to the growth in NOPAT during the terminal period.

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 CONFIDENTIAL

Example of FCF Valuation

FCF Example

Initial Growth 20% Value of Explicit FCF -112

Terminal Growth 5% Value of Terminal Period 2,028
Initial ROIC 15% Total Value 1,916
Terminal ROIIC 10%
WACC 10%

Year 0 1 2 3 4 5 6
Sales 1,000 1,200 1,440 1,728 2,074 2,177
NOPAT 150 180 216 259 311 327

Working Capital 500 600 720 864 1,037 1,115 1,196

Net Fixed Assets 500 600 720 864 1,037 1,115 1,196
Invested Capital 1,000 1,200 1,440 1,728 2,074 2,229 2,392
0.1
NOPAT 150 180 216 259 311 327
- Investment 200 240 288 346 156 163
FCF -50 -60 -72 -86 156 163

Metrics
FCF -50 -60 -72 -86 156 163
EP 50 60 72 86 104 104
ROIC 15% 15% 15% 15% 15% 15%
NOPAT Growth 20% 20% 20% 20% 5%
Invested Capital Growth 20% 20% 20% 20% 8% 7%
Investment Growth 20% 20% 20% -55% 5%

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 CONFIDENTIAL

Tips & Tricks for FCF Valuation (2)

The use of NOPAT in the Gordon growth model is an aggressive assumption which
implies incremental investments have an infinite return. It is a common mistake that can
cause an enormous error in the valuation.

Can the terminal period be valued with NOPAT in the Gordon growth model?

N
NOPATN +1
Value = ∑ FCFi +
i =1 (DR − g )(1 + DR )N
Overestimates the value by the amount:

⎛ g ⎞ This is the change in invested capital

NOPATN +1 ⎜⎜ ⎟⎟
and is not taken in to account in the
Error = ⎝ ROIC I ⎠ equation above. NOPAT cannot grow
(DR − g )(1 + DR )N without CAPEX!!

FCF = NOPAT – Change in Invested Capital ≠ NOPAT

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 CONFIDENTIAL

Tips & Tricks for FCF Valuation (3)

Growth doesn’t matter when ROICI = DR ! Simply use the perpetuity equation.

The NOPAT perpetuity equation is correct when growth =0 or ROIC = DR.

⎛ g ⎞
NOPAT N +1 ⎜ 1 − ⎟ N
⎠ = FCF + NOPATN +1
N
⎝ DR
Value = ∑ FCFi +
i =1 (DR − g )(1 + DR )N ∑ i =1
i
DR(1 + DR )
N

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 CONFIDENTIAL

FCF Sensitivity Model – terminal value considerations

1 2 3 4 5 6
ROIC 15% 15% 15% 15% 15% 15%
Inve ste d Ca pita l Grow th 10% 10% 10% 10% 10% 3%
Long Run Grow th 3%
NOPAT 150 165 182 200 220 242
Inve ste d Ca pita l 1,000 1,100 1,210 1,331 1,464 1,611 1,659
CAPEX 110 121 133 146 48

FCF 50 55 61 67 73 193
PV Fa ctor 10% 0.91 0.83 0.75 0.68 0.62 0.56
PV FCF 45 45 45 45 45 109

Va lua tions T6 Va lue PV EV

Fore ca st 227
T6NOPAT/W ACC 2,416 1,500 1,727
T6NOPAT/(W ACC-g) 3,451 2,143 2,370
T5FCF/W ACC 732 455 682
T5FCF*(1+g)/(W ACC-g) 1,077 669 896
T6FCF/(W ACC-g) 2,761 1,714 1,942
Fa de Va lua tion 1,325 1,552

FCF = ICo x (ROIC – g)

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 CONFIDENTIAL

Calculating the Terminal Value of a Firm

Also called perpetual, continuing or residual value, the terminal value is an estimate of
the firm’s value after its forecasted growth phase is complete.

Corporate Value of Forecast Value of Terminal

Value Period Period

Economic Profit Terminal Period Valuation

∞
EPi
Value = InvestedCapital 0 + ∑
i =1 (1 + DR )i

EPi = (ROIC − DR ) × InvestedCapital i −1 = EPN +1 (1 + g )

i − N −1
for i > N

∞
N
EPi
Value = InvestedCapital 0 + ∑ EPi + ∑ (1 + DR ) i
i =1 i = N +1

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 CONFIDENTIAL

EP Terminal Period Valuation

Simple analytical solutions can be derived for the valuation of the terminal period if
growth and returns are assumed to be constant.
(1) Zero Growth Trick: use perpetuity model

EPN +1 = (ROIC − DR )× InvestedCapital N

N ∞
(ROIC − DR ) × InvestedCapital N
Value = InvestedCapital 0 + ∑ EPi + ∑
i =1 i = N +1 (1 + DR )i
N
(ROIC − DR ) × InvestedCapital N Dividing by the discount rate
Value = InvestedCapital 0 + ∑ EPi + creates the perpetuity
DR(1 + DR )
N
i =1

(2) Constant Growth Trick: use Gordon growth model

N ∞
(ROIC − DR ) × InvestedCapital N (1 + g )i − N −1
Value = InvestedCapital 0 + ∑ EPi + ∑
i =1 i = N +1 (1 + DR )i
Grow the EP by one year
N
(ROIC − DR ) × InvestedCapital N and then divide by (DR-g)
Value = InvestedCapital 0 + ∑ EPi +
i =1 (DR − g )(1 + DR )N

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 CONFIDENTIAL

Tips & Tricks for EP Valuation (1)

New investments made in the terminal period have a return of ROICI. Investments made
during the explicit period maintain their last explicit return ad infinitum. Growth in this
case refers to the growth in NOPAT during the terminal period.

What if returns in the explicit and terminal period are different?

⎛ g ⎞
NOPATN +1 ⎜⎜ ⎟⎟(ROIC I − DR )
EPN +1 ⎝ ROIC I ⎠
N
Value = InvCap0 + ∑ EPi + +
DR(1 + DR ) DR(DR − g )(1 + DR )
N N
i =1

Growth in this equation refers to the growth in NOPAT during the terminal period.

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 CONFIDENTIAL

Example of EP Valuation

EP Example

Initial Growth 20% Invested Capital 1,000

Terminal Growth 5% Value of Explicit EP 273
Initial ROIC 15% Value of Terminal Period 644
Terminal ROIIC 10% Total Value 1,916
WACC 10%

Year 0 1 2 3 4 5 6
Sales 1,000 1,200 1,440 1,728 2,074 2,177
NOPAT 150 180 216 259 311 327

Working Capital 500 600 720 864 1,037 1,115 1,196

Net Fixed Assets 500 600 720 864 1,037 1,115 1,196
Invested Capital 1,000 1,200 1,440 1,728 2,074 2,229 2,392
0.1
NOPAT 150 180 216 259 311 327
- Capital Charge 100 120 144 173 207 223
EP 50 60 72 86 104 104

Metrics
FCF -50 -60 -72 -86 156 163
EP 50 60 72 86 104 104
ROIC 15% 15% 15% 15% 15% 15%
NOPAT Growth 20% 20% 20% 20% 5%
Invested Capital Growth 20% 20% 20% 20% 8% 7%
Investment Growth 20% 20% 20% 20% 8%

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 CONFIDENTIAL

Tips & Tricks for EP Valuation (2)

Fading the economic profit to zero is an excellent application of the Gordon growth
model.

Can the value of a fading EP stream be valued?

EPi +1 = EPi (1 − f ) for i > N

EP (1 − f ) EPN +1 (1 − f ) EPN +1 (1 − f ) (1− f )

2 i −1 ∞ i −1
EPN +1
TV = + N +1 + K + = EPN +1 ∑
(1 + DR ) (1 + DR )2 (1 + DR )3 (1 + DR )i i =1 (1 + DR )
i

The equation has the same form as the Gordon growth model:

EPN +1
TV =
(DR + f )
N
EPN +1
Value = InvestedCapital 0 + ∑ EPi +
i =1 (DR + f )(1 + DR )N

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 CONFIDENTIAL

Which Metric Is the Better Measure of Value?

Economic Profit is a useful measure for understanding a company’s performance in any

single year, while Free Cash Flow is not. Economic profit translates the value drivers
ROIC and growth into a single figure.

PVof FCFandGrowthTrajectory PVof EPand ROICTrajectory

250 25.0% 180 16.0%

200 160 14.0%
150 20.0% 140
12.0%
100
120
50 10.0%

PV of EP
15.0% 100
PV of FCF

PV of EP

ROIC
Growth
0 PV of FCF 8.0%
80 ROIC
-50 1 5 9 13 17 21 25 29 33 37 Growth
10.0% 6.0%
-100 60
4.0%
-150 40

-200 5.0% 20 2.0%

-250 0 0.0%
-300 0.0% 1 5 9 13 17 21 25 29 33 37
Year Year

FCF Analysis EP Analysis

• FCF < 0 when g > ROIC • EP > 0 when ROIC > DR
• Negative FCF is not necessarily bad • Positive EP indicates wealth creation
Assumptions: Explicit growth of 20%; explicit ROIC of 14%; LT growth of 5%; DR of 10%; and fade rate of 10%.

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 CONFIDENTIAL

DCF Valuation – Common Errors

Forecast horizon too short – terminal value too high (>90%)

Uneconomic continuing value – no reversion to mean returns
Cost of capital – focus on value drivers instead
Mismatch between earnings and investment growth – Capex vs earnings
Improper reflection of other liabilities - pensions
Premium to public market value – increasing value to private buyer
Double counting – using new debt and acquisition
Scenarios – too few hence too much reliance on a single point valuation

Source: Mauboussin on Strategy, Legg Mason Capital Management, March 2006.

http://www.lmcm.com/pdf/CommonErrors.pdf

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 CONFIDENTIAL

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